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Investing Strategies: International Investing

U.S.A.! U.S.A.! Victor of two world wars, innovator of the airplane and automobile, creator of Hollywood and the Internet, and home of the blues, jazz, and rock 'n' roll ... and the best-performing market of the 20th century. Right?

Alas, that last part's not true. Sure, by the time we rang in Y2K, the United States was the economic powerhouse of the world. But from 1900 to 2000, the country with the best after-inflation annual return was Sweden (7.6% a year), followed by Australia (7.5%), and then South Africa (6.8%), according to Triumph of the Optimists, the academic bible of international investing. The U.S. came in fourth at 6.7% -- tack on inflation, and you get that 10% you always hear about.

Furthermore, America's dominant global economic position is a question mark for the century ahead. But we do have this bit of history: Back in 1900, the largest stock market in the world was in the United Kingdom -- the economic leader of 1900. Today, the U.K. is No. 3, behind the U.S. and Japan. British stocks returned 5.8% a year in the 20th century, coming in seventh, behind the aforementioned four countries, Canada, and the Netherlands.

The U.S. stock market hasn't historically provided the highest returns, and the future is uncertain. So why should all your money be in U.S. stocks?

Importing returnsDon't get me wrong -- I'm not saying that the U.S. will cease to be an economic player. But adding international investments to your portfolio can give you a boost in returns and reduction in risk in the form of greater diversification. The early 2000s perfectly illustrated the value of international investing. Just compare the returns from 2002 to 2007 of the Vanguard 500 Index (VFINX), a fund that tracks the performance of the S&P 500, with those of four choice international mutual funds:

Fund

2002-07 Annualized Return

Vanguard 500 Index (VFINX)

12.9%

Dodge & Cox International Stock Fund (DODFX)

27.2%

Fidelity Spartan International Index (FSIIX)

21.8%

T. Rowe Price International Equity Index (PIEQX)

21.6%

Vanguard Total International Stock Index (VGTSX)

23.9%

Source: Morningstar data through Dec. 27, 2007.

Booming business overseas isn't the only engine powering international returns. When you invest abroad, another crucial factor affects your success: the change in value of foreign currencies relative to the U.S. dollar.

Dog days of the dollarThe greenback has taken a walloping. It's down big against both major-market currencies like the euro and yen, as well as emerging-market denominations like the Chinese yuan and Brazilian real. That led to outstanding returns for international investments.

The managers at Dodge & Cox International Stock Fund, for instance, estimated that one-third of their 16% annual average return from 2001 to 2007 owed to the dollar's decline. For the most common barometer of international stocks -- the Morgan Stanley Capital International Europe, Australasia, and Far East Index (mercifully better known as the MSCI EAFE, or just EAFE) -- about half of the index's returns stemmed from changes in currency valuations.

Key metrics1. Developed vs. emerging. With almost 200 countries in the world, dividing your portfolio into just "U.S." and "international" is too simplistic, especially when each country is at a different stage of development. A good first step is to break up your international portfolio into developed countries (e.g., the U.K., Canada, Japan) and emerging countries (e.g., China, South Korea, Brazil).

The emerging countries have historically given investors a better return, but with higher risk. For instance, the MSCI Emerging Markets Index returned an astounding 33.4% annually from 2002 to 2007, compared to "just" 19.2% for the EAFE (which comprises stocks of more developed countries). But the Emerging Markets Index hit a peak in September 1994 -- and then fell off a cliff. That previous peak wasn't exceeded until February 2005. An investment in emerging-markets stocks is a very long-term prospect -- especially after such spectacular returns. They can go down quickly and stay down for years.

2. Region by region. In All About Asset Allocation and The ETF Book, money manager Richard Ferri found that he enhanced international returns by breaking up a portfolio by region and rebalancing regularly. Instead of investing in one investment that matches the EAFE, invest 25% in the U.K., 25% in MSCI Europe (excluding U.K. stocks), 25% in MSCI Japan, and 25% in MSCI Pacific Rim (excluding Japan). Rebalanced annually, from 1970 to 2004 your returns would have beaten the EAFE by 1.7 percentage points a year.

1970-2004

EAFE

EAFE Broken Into 4 Regions

Annual return

10.4%

12.1%

Standard deviation

22.3

22.3

Best year

69.4%

66.2%

Worst year

(23.4%)

(24.5%)

Source: All About Asset Allocation, by Richard Ferri. Returns are net of dividends.

This happens because EAFE components and their currencies don't move in lockstep. And when you regularly rebalance a portfolio of volatile and relatively uncorrelated assets, you can potentially increase returns.

3. Costs and taxes. If you'll be investing in international mutual funds or exchange-traded funds, be prepared to pay roughly 30 basis points (0.30%) more in expenses over a comparable domestic fund. Also, there's a tax quirk: Other countries may require U.S. investors to pay taxes on dividends and interest. But Uncle Sam allows investors to either claim those taxes as an itemized deduction, or claim the foreign tax credit. To see whether you paid foreign taxes, check box 6 of the Form 1099-DIV you receive at the end of the year from your broker, dividend reinvestment plan, or mutual fund.

Despite the prevalence of prognosticators, no one can really predict the future, especially when it comes to the behavior of 7 billion people across the globe. Thus, putting some of your really long-term assets -- money you don't need for a decade or longer -- in international investments offers the best opportunity to benefit from worldwide growth and potentially lower the overall risk of your portfolio.

For more on international investing, check out our Motley Fool Global Gains newsletter. It provides in-depth coverage of global investments, with stock recommendations and commentary that will get you up to speed on the world beyond the U.S. You can take a free look with a 30-day trial.

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